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Chapter 16

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CHAPTER 16

THE MANAGEMENT OF WORKING CAPITAL
FOCUS
Day to day business runs on working capital. We can't do without it, but we'd like to use as
little as possible. Our focus is on understanding what's involved in running the routine aspects of a
business effectively without wasting resources. That means understanding the implications of decisions
about each of the working capital accounts and about how working capital is financed.
PEDAGOGY
Our approach is especially practical in this area. We stay away from optimization models and
concentrate on trade-offs that are generally analyzed with a little math and a lot of intuition. We provide
a special insight into internal relations and company politics in the area of receivables.
TEACHING OBJECTIVES
In this chapter students should gain an insight into the short term operating nature of working
capital and its importance in running any company. In particular they should understand that working
capital requires financing and appreciate the short term sources of funds available to support operating
needs. Further they should have a detailed understanding of the issues and problems associated with
managing each of the three major working capital assets: cash, receivables and inventories.
OUTLINE
I.

WORKING CAPITAL BASICS
The short term nature of the assets and liabilities that arise from routine operations.
A. Working Capital, Funding Requirements, and the Current Accounts
The conceptual relationship between working capital and the current accounts. The need to
fund net working capital. Spontaneous financing.
B. The Objective of Working Capital Management
Running the firm effectively with as little as possible tied up in W/C.
C. Operations - The Cash Conversion Cycle
Two graphic portrayals of how cash flows in and out of a company and through the working
capital accounts.
D. Permanent and Temporary Working Capital
The variation in W/C with business activity.
E. Financing Net Working Capital
W/C lends itself to short term financing.
Financing policies with respect to permanent and temporary W/C.
F. Working Capital Policy
The elements of W/C policy defined.

II. SOURCES OF SHORT TERM FINANCING
A. Spontaneous Financing
The nature of accruals and payables. Credit terms, prompt payment discounts
B. Unsecured Bank Loans
Notes, lines, revolvers, compensating balances.
C. Commercial Paper
The nature of commercial paper and its issuers.

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Chapter 16
D. Short-Term Credit Secured by Current Assets
Pledging and factoring receivables. Inventory financing, liens and warehousing.

III. CASH MANAGEMENT
A. Definitions and Objectives
The motives for holding cash and the objective of achieving adequate liquidity while tying up
minimum resources.
B. Marketable Securities
Near cash liquidity with a modest return.
C. Check Disbursement and Collection Procedures
The check collection/clearing system and how it works.
D. Accelerating Cash Receipts
Lock boxes, concentration banking, wire transfers.
E. Managing Cash Outflow
Central vs. local cash management, remote disbursing.
F. Evaluating the Cost of Cash Management Services
Cost benefit analyses to determine if cash management systems are worthwhile.
IV. MANAGING ACCOUNTS RECEIVABLE
A. Objectives and Policy
The balance between more revenue with easy customer relations and potential bad debt losses.
A shared responsibility with sales.
B. Determinants of the Receivables Balance
Credit policy, terms of sale, collection policy, and the conflict with sales.
C. Summary and Conclusion- A Practical Management Warning
The politics of uncollected receivables can be a career pitfall for the CFO.
V. INVENTORY MANAGEMENT
Finance generally has an oversight responsibility for inventory management.
A. Who Is Responsible for Inventory
The primary responsibility is generally in manufacturing or operations. Finance has an
oversight function.
B. The Benefits and Costs of Carrying Inventory
Business runs smoother with more inventory but the costs include interest, storage, insurance,
and taxes along with exposure to shrinkage and obsolescence.
C. Inventory Control and Management
Balancing the costs and benefits of inventory.
D. The Economic Order Quantity (EOQ) Model
The popular model to balance ordering and carrying costs.
E. Safety Stocks, Reorder Points, and Lead Times
The concepts incorporated with the EOQ model.
F. Tracking Inventories - the ABC System
The effort expended in control should be related to the cost and importance of the inventory.
G. Just In Time (JIT) Inventory Systems
The objective of JIT and the practical limitations on its use.
QUESTIONS
1.
Explain the different circumstances under which firms should use short-term or long-term
financing.

Money should be repayable when whatever it finances generates cash. but the items within it change). 4. don't have to be paid for immediately. They "turn over" constantly (there's always inventory. Such a policy implies funds will always be available for short-term needs. or a little of both? Exactly what is meant by spontaneous financing? Does working capital require funding? Why? ANSWER: The statement is partially true. Financing long-term items with short-term money tends to reduce interest costs (short rates are generally lower). These things are generally funded with money that doesn't have to be paid back for similarly long periods like equity and long term loans. Typically. Describe the maturity matching principle. the underlying assets in which the value resides turn over constantly. mainly inventory and labor. Spontaneous financing refers to the fact that some resources. The working capital concept involves the assets and liabilities that arise from the normal day to day activities of a business. Hence net working capital. but exposes one to the risk that refinancing will be either expensive or unavailable sometime during the item's life. These are only roughly equivalent to the current accounts in most companies. or is forced into the situation because long-term money isn't available. What are the risks of not matching maturities? How would you characterize a firm that ignores the principle? Can you think of situations in which it would be advisable for an otherwise prudent firm to deviate from the principle? ANSWER: The maturity matching principle says that financing to support assets (and projects) should be repayable at the time those items generate enough cash to make the repayments. Short-term items like inventory and receivables come and go quickly. 3. Therefore banks are willing to make short-term loans based on those items. They remain on the balance sheet because new inventory and labor are being acquired and used all the time. Working capital is generally defined as the difference between current assets and current liabilities. Is this statement true. Is this definition precisely correct? Why? ANSWER: No.The Management of Working Capital 124 ANSWER: Whether financing should be long or short term depends on the longevity of the things it's used to support. This can occur if management is imprudent or ignorant. A firm that does that exposes itself to additional financial risk. Working capital spontaneously finances itself because it's being turned over all the time. but is conservative rather than risky. Either refute or support that statement. Things like prepaid expenses and the current portion of long term debt are included in the current accounts but conceptually aren't working capital items. Long-term money is used to acquire things that remain with the firm for substantial periods such as fixed assets or extended projects. spontaneous financing supports only a fraction of working capital requirements. . however. false. but they may be more expensive than if acquired short term. The idea of short or long term financing is related to the maturity matching principle. Because companies always have inventory and accounts receivable. These unpaid liabilities are reflected in the payables and accruals accounts. the difference between gross working capital (current assets) and spontaneous financing (current liabilities). Financing short-term needs with long-term money ignores the maturity matching principle. These assets are generally funded by trade credit or by short term borrowing that has to be repaid in a relatively brief period. most banks are happy to make long term loans to support those assets. 2. Some very risk-averse managers feel this is the right thing to do. requires funding. Although firms always have inventory and receivables. ANSWER: The statement isn't true. 5.

It certainly doesn't reduce the need for financing. and can vary over the year if volume is seasonal. Temporary working capital is the increase over the minimum level required when seasonal increases occur. Because temporary equipment is usually of lower quality than permanent material. The CFO has asked you to prepare a memo for his signature outlining why this may not be the best strategy. they don't require financing. on the other hand. Building the product. 10. Therefore cash requires financing. is very profit oriented. Permanent working capital refers to the minimum level required during an annual cycle. The firm's owner and CEO. Support or challenge each of the following statements individually: a. the firm "buys" an account balance at the bank. because of their different terms. It makes sense to finance these items separately. Fixed assets. 7.125 Chapter 16 6. which is quite prosperous. outline the working capital financing options available to most firms and discuss the trade-offs involved in using long term versus short term financing . a friend in the engineering department said she'd heard that the firm used a lot of temporary working capital. You work in the finance department of HiTech Inc. Working capital refers to the assets and liabilities that arise from the everyday running of the business including cash. There isn't a quality issue in the distinction. This situation lends itself to short term financing. ANSWER: a. The term operating cycle refers to both the sequence of events and the time required to go through it once. 8. How does a firm's operating cycle differ from its cash conversion cycle? Explain fully. You work in the finance department of a manufacturing company. He understands that short-term interest rates are quite low at the moment. which is the time between receiving and paying for inventory. Over lunch. Why does it make sense to finance net working capital separately from fixed assets? ANSWER: The assets making up working capital turn over regularly in short periods. Cash is money in the bank available to pay bills and transact business. In effect. receivables require funding. require commitments of funds for long periods. and inventory. ANSWER: A business's operating cycle begins with the purchase of inventory that in time is turned into product and sold. These things depend on the level of business being done at a point in time. Cash represents a pool of available money. The sale results in a receivable that becomes cash when collected. requires cash that isn't recovered until the receivable is collected. however. she wonders why the company. so it actually reduces financing needs. Because accounts receivables aren't purchased like inventory or fixed assets. Therefore. They also tend to generate cash shortly after they're held. b. b. The cash conversion cycle is the operating cycle in days less the payables deferral period. The cash is used to purchase more inventory starting the cycle again. That money has to be deposited and therefore represents an asset just like a machine or an inventory item. ANSWER: Your friend probably thinks working capital is an asset that's purchased like a machine or building. and has suggested that the firm finance all of its working capital needs with short term loans. In this misconception she's confusing working capital with capital equipment. What misconceptions does your friend have? Write a brief explanation for someone who knows nothing about finance to straighten out her understanding. In your memo. 9. Charlie Dollars. less payables and accruals. receivables. doesn't buy the best and store it when it isn't needed. A receivable is generated when product is shipped reflecting the fact that a sale has been made.

would you do it? Why or why not? ANSWER: Slowing cash payments to vendors is known as stretching payables or leaning on the trade. because short rates do sometimes exceed long rates. Individual loans made under either a line or a revolver may have separate promissory notes. Worse. The practice conserves the payer's cash reducing the need for working capital financing which saves interest expense. 13. who then takes care of collection. Factoring means actually selling the receivable to the factor. 14. It generally means paying in a longer period than specified by the terms of sale. which include the information in their reports. Factoring is more expensive because the financial institution does more work. 11. This can cause disruptions in the slow payers production and administrative processes. Explain the difference between pledging and factoring receivables. In extreme cases suppliers refuse to make further credit sales to slow paying customers demanding cash in advance. Vendors report slow payers to credit bureaus. What's the difference between a promissory note. paying vendors slowly today can keep you from getting a bank loan or credit from a new vendor tomorrow. How can this come about? ANSWER: If the factor pays its customer (the firm selling the receivable) before money is collected from the customer. might one be part of the other? ANSWER: A promissory note is a contractual document associated with a specific loan. Most vendors will tolerate a little tardiness. The line is informal meaning the unused portion can be revoked by the bank at any time. A line of credit and a revolving credit agreement are agreements between a company and a bank as to the maximum amount the firm can borrow during a specified period.or long-term funds. Short-term money is always borrowed while long-term funds can be either debt or equity. Stretching payables also affects a firm's credit rating. Being labeled a slow payer makes it more difficult to get credit of any kind. In such cases the factor's charges have to include interest for that interim period. The firm that stretches payables walks a fine line. because it suddenly has no way to sustain its working capital requirements. This creates a risk. What are the advantages and disadvantages of stretching payables? If you owned your own business. Short-term financing is usually cheaper (lower interest) but has to be renewed periodically as loans become due for repayment. the trick is not to overdo it. in order not to risk ruin. That can put a company out of business.The Management of Working Capital 126 ANSWER: Working capital can be financed by either short. The disadvantage is that it offends suppliers who want to be paid on time making them reluctant to do business with the slow payer. it is out funds until collection is actually made. 12. Factoring may involve interest even though it isn't a loan. situations occasionally occur in which refinancing isn't available at any rate. This means a strategy of supporting working capital with short-term borrowing requires a continuous series of new loans. Whether you would do it or not is a matter of personal preference. The accounts continue to belong to the borrowing company. Therefore. most companies limit their short term financing. Which is likely to be more a more expensive source of financing? Is factoring the same kind of financing as pledging? ANSWER: Pledging involves borrowing money based on the collateral value of receivables. The revolver is a commitment to have funds available and requires a commitment fee on unused balances. and a revolving credit agreement? Are they mutually exclusive? That is. and use some long-term debt and/or equity to support working capital. which is responsible for their administration and collection. . a line of credit. In other words.

Suggest a way to fix this problem and explain how it will work. when she receives a check. Having enough cash is known as having adequate liquidity The problem associated with holding cash is that it earn a very small return if any at all. operates out of Waco. Each operation has several bank accounts to receive deposits and pay vendors. and does business with a large. the rather substantial cash total isn't earning anything because it's too dispersed to be invested in marketable securities. Texas. What can the company do to speed things up? Explain how your solution would work. she mails it to a local address in Baltimore.. You're the cash manager for Huge Inc. Receipts travel a short distance so the firm gets its money quickly. The Johnson sisters have a right to be upset. Third party warehousing companies are able to do that. on the other hand. When she sends the broker a check. Maine. 17. It seems to take a particularly long time for the Portland customers' payment checks to reach Medco. it comes from San Francisco. Her sister Joan lives in Los Angeles and uses the same firm. which has factories and stores all over the country. travel cross-country keeping customers' funds in the firm's account a few days longer where it earns interest. national brokerage firm. It may also be necessary to hold cash to satisfy compensating balance requirements. Customers in that area would mail payment checks to the Portland lockbox which would be deposited in the check clearing system by the bank immediately. but receives checks from an office in Miami. ANSWER: Medco's mail float from Maine can be reduced by installing a lockbox in Portland that is operated by a local bank. Marketable securities help in achieving the objective because they provide nearly the liquidity of cash. Disbursements. but their services are expensive. Outline the reasons for holding cash and the big cost associated with it. This makes continuous monitoring necessary for complete security. The difficulty arises because the borrower needs to continue to use the inventory during the financing period. This kind of dealing is a violation of the trust inherent in the broker-client relationship (called a fiduciary relationship). Sally Johnson lives in Baltimore. What is the biggest problem associated with financing secured by inventory? How is it addressed in practice? ANSWER: The biggest administrative difficulty associated with inventory financing is keeping track of the secured material and making sure it's available to the lender in the event of default. It's essential that those divisional executives have control of their cash to run their operations effectively. The Medco Supply Co.127 Chapter 16 15. 18. to provide the capability of handling emergencies (precautionary demand). Therefore it isn't wise to tie up any more money than necessary in cash balances. . She mails payments to an office a few blocks from her home. 16. so the company's cash is spread all over the country under the control of divisional CFO's. from the broker. 19. How do these lead to the objective of cash management? How do marketable securities help or hinder achievement of the objective? ANSWER: Cash is held to conduct normal business activities (transactions demand). The objective of cash management is to balance the need for liquidity with cost of holding extra cash. However. but also offer a modest return. and has a number of customers around Portland. What's going on? Should the Johnson sisters be upset? ANSWER: The brokerage firm is playing the mail float to its advantage at the expense of clients. This avoids the delay of mailing all the way to Texas. and to take advantage of unexpected opportunities (speculative demand). However.

Finance rarely has a direct responsibility for inventory. Sam Spade. 25. Inventory management is far from an exact science. Cash management systems should only be used if they save money. The central balance is likely to be large enough to be invested effectively. However. In small firms the cash volume affected by a system may not be large enough to generate interest savings sufficient to cover its cost. Is that statement true or false? Explain. The Philipps Lighting Company manufactures decorative light fixtures. 22. the vice president of manufacturing is a . 20. Manufacturing or operations executives usually determine what and how much to carry. which reduces the amount of working capital financing needed. For the system to be cost effective. Inventory management is a shared responsibility between finance and manufacturing just as receivables management involves both sales and finance. and sweeps excess amounts into a central account. Hence when EOQ is combined with a safety stock the overall model does help to manage stockouts. Does the EOQ model properly applied prevent stockouts? Does it address stockouts at all? Do you think the EOQ model solves very many of management's inventory problems? ANSWER: The EOQ model itself doesn't address stockouts. Its revenues are about $100 million a year. ANSWER: Wrong. In such cases sophisticated techniques shouldn't be used. The cost generally involves a fixed annual fee for setup and maintenance and a variable charge related to volume. 23. Right or wrong? Explain. the interest savings it generates have to exceed its total cost. These issues are a small part of overall inventory management.The Management of Working Capital 128 ANSWER: Huge should consider concentration banking in which a single bank monitors the amounts in remote locations daily. Every company should take full advantage of the sophisticated cash management services offered by today's banking industry. It purchases inputs from approximately 20 suppliers most of which are much larger companies located in various parts of the country. Finance has an overview responsibility to ensure inventory is usable and current and that the firm isn't carrying more than it needs. attention to detail. and that the subject is more precise than it actually is. This reduces bad debt losses but also tends to offend customers and lower sales. it may give the impression that there's less to inventory management than there really is. and there's no excuse for not having the optimal quantity on hand at all times. EOQ itself just balances the cost of ordering against the cost of holding inventory. ANSWER: False. Cost effective inventories are achieved through frequent reviews of what is needed and what is on hand. 21. The benefit of sophisticated systems is that they reduce cash balances. and a combination of manual and automated tracking systems. ANSWER: A tighter receivables policy means credit is granted only to higher quality customers and overdue receivables are pursued more aggressively. inventory management is a precise science. Because of the advances in computer technology. EOQ is presented in most text because it is concise and easy to understand. ANSWER: Wrong. The safety stock concept does. which in turn saves on interest expense. Outline the costs and benefits involved in the trade-off between a tighter versus a looser receivables policy. Right or wrong? Explain. 24.

including orchestrating timely JIT deliveries. ANSWER: Reducing current assets and increasing current liabilities reduces the money tied up in working capital. but it has two important practical problems. it's hard to imagine that they would be willing to go to the trouble of managing JIT shipments for us. The firm using JIT is essentially pushing the task of carrying its inventory back onto its suppliers. tactfully outlining the problems and risks involved in Sam's proposal. Stretching payables offends vendors and can lead to higher prices for input and delays in resupply. That reduces related borrowing and saves interest expense. Further. Just in time (JIT) is the wave of the future. Fred's suggestion is probably too drastic and might hurt more than it helps. explain why this statement isn't absolutely true. That means the trucker also has to commit to precisely timed deliveries to make the JIT idea work. Collecting receivables too aggressively offends customers and can reduce sales. Fred Eyeshade is an analyst in your group who transferred from the accounting department a short time ago. Explain why this might not be a good idea with respect to each of the elements of net working capital (four accounts). Prepare a memo to the team. That can be almost impossible if large distances are involved. Distance is another complicating factor. 2. That firm will go to any lengths to keep GM's business. If suppliers are located far away. and receivables along with a doubling of payables to reduce the firm's financing needs for net working capital. a trucking company is between them and the JIT company. Too little inventory in production can cause expensive idle time and missed schedules. and sells 90% of its output to General Motors. Last week Sam came into a meeting of the executive team with a proposal to cut inventory costs to almost nothing. This would be a big problem in our case. ANSWER: Staff: JIT is a great idea in theory. and proposed that Philipps enter into negotiations with of all its suppliers to implement the concept immediately. inventory. You're a supervisor in the treasury department of Big Corp. That means the suppliers have to be willing to work very hard to maintain the inventory and to ensure precisely timed shipments arrive "just in time" for production. For example. A lack of inventory can also cause stockouts at the point of sale. since our suppliers are from several hundred to thousands of miles away. However these actions can be overdone. In summary.129 Chapter 16 sophisticated executive who has always been very impressed by the latest innovative techniques in management. which delay customer orders and can result in lost business. If the piston ring manufacturer sold its output to 20 or 30 different customers. BUSINESS ANALYSIS 1. Suppliers are generally willing to do that only if the customer using JIT is very important to them. although JIT has some benefits for very large and powerful companies. he said. With respect to receivables and inventory. the risks of JIT are substantial. If we're not carrying inventory and a promised shipment fails to arrive. I doubt that it will be feasible for us. You're the CFO and tend to be more skeptical about new methods. Recently there's been increasing concern about the firm's rising interest costs. He has suggested that senior management mandate a 50% across the board cut in cash. Since Philipps doesn't buy a large portion of the output of any of our suppliers. Things tend to run more smoothly and efficiently with more working capital. In other words. everything stops. suppose a company makes piston rings. too little cash can make it impossible to pay bills on time and conduct business efficiently. it wouldn't be particularly motivated to do JIT for any of them. Similarly. Unless working capital is being managed very poorly. That can obviously be very costly. why might a very large inventory or receivables balance not do much good at all? .

To the loan committee your business is a high-risk venture with a good chance of failure which implies a default on their loan. He thinks banks shouldn't get any more than 4% or 5%. The bank has to be compensated with interest for bearing that risk. but doesn't really know why he feels that way. minimum balances are a standard practice designed to "compensate" banks for their services. Admittedly. Several months ago the marketing department initiated a program to attract new customers to counteract the downward sales trend. a rate that does seem excessively high. This would have been 12% / . which sells windows to residential builders. The bank lends businesses money it "borrows" from depositors. In both cases the items are "inactive. and collection efforts have been less successful than usual. 4. The other thing Harry should keep in mind is risk from the bank's viewpoint. He then stormed out of the meeting. newer builders if it was going to keep sales up. Harry probably doesn't understand two things about the loan business. rather than at the bank. You and your friend Harry have started a business. and make a profit. but the VP of marketing says they don't have time because "reps have to be out on the street selling. there's been a slump in the housing industry and Wachusett's sales have slowed. and has demanded to know why Finance has let it happen. Spreads are generally between five and ten percent. When interest rates are up. It seems that the bank is being devious by quoting 12% when it's actually charging 15%. Hearing this. They don't help in running the company because they aren't used for anything. Out of that the bank has to pay all of its operating costs. Harry is especially bothered by the rate. Harry pulled out his calculator and made a calculation at which he became outraged. Prepare a memo explaining the processes behind the creation and . but doesn't know much about business or finance. but the bank doesn't get to keep any more money that it does when rates are lower. In that case all of the loaned money can be used at times as long as an average balance of at least 20% is maintained. At the time the president overruled your concerns about the credit quality of such customers. thinly capitalized construction companies that are frequently short of cash. Things may not be as bad as they seem if the requirement is for an average minimum balance. More recently receivables have gone up substantially. Why is Harry so upset? What calculation did he make? Write a short memo explaining banking practices to calm Harry down. Further. 3." The president has suddenly become concerned about the receivables increase. Collectors have asked for help from sales representatives in chasing down delinquent customers. which usually reflect inflation. 12%. it's hard for entrepreneurs to identify with that view of themselves. When you both were about to sign the loan papers the banker mentioned that a minimum balance of $20. The firm's customers tend to be small. Over the past year. He personally approved a number of accounts brought in by the sales department that ordinarily wouldn't have qualified for credit. A big inventory account can imply material that's useless because it's damaged or obsolete. the bank's cost and its risk. However. Harry is a technical whiz. cover loans that default.8 = 15%. both of these rates are high. The VP of Marketing and the president agreed that the firm would have to deal with even smaller. You're the CFO of the Wachusett Window Company. and operates on the "spread" between the interest it pays out and the rate it charges on loans. You might have done that anyway." and lie under the things that are turning over.000 would have to remain in the bank.The Management of Working Capital 130 ANSWER: Large balances in receivables may indicate the presence of uncollectible items that should be written off.000 bank loan at what seems to be a rather high interest rate. After several months you've been approved for a $100. Harry's anger should be directed at generally high rates. Is there a kind of minimum balance requirement that might make Harry's calculation invalid? ANSWER: Harry's calculation probably figured the effective interest rate on the loan with a 20% minimum compensating balance.

"I told you so. because they made the decision to lower credit standards over the CFO's objection. the less likely they are to be collected. This needs to happen quickly. Unfortunately. There's very likely to be a write-off required.) 5. The approval by the credit department is key to the idea that finance is responsible for collection. Many top executives don't like to admit that they were wrong. and it's relatively hard for collectors to get to the customer's executives. is responsible for delivering customers.. we can't supply any more product. tends to have an ongoing relationship with people higher up in the customer organization who can prioritize bill payments. on the other hand. and then to quickly focus on the team effort required to fix the problem. In our current situation. do you think a higher prompt payment discount alongside the new sales program would have kept receivables down? Why? . When a receivable isn't paid. The sales department.. however. Tactfully explain why the blame should not be placed solely on the finance department. However. tend to be with lower level administrative personnel. Those contacts. Also notice the last paragraph. However. because of the nature of the customers involved. It would be unwise to give the impression that everything will be ok if you get some help from sales.." to your boss isn't likely to get you anything but grief. it's possible that the CFO is going to be the scapegoat in this situation regardless of what he or she does.131 Chapter 16 management of receivables and explain what's behind the increase. that relationship can be crucial to successful collection of the account. The sales force. Particularly notice the wording in the fourth paragraph "we" made the decision. on the other hand. Rejection signifies a high probability that the account will not be collected and will result in a loss. In problem situations. Saying. the appropriate management of problem accounts calls for consideration of how they arise in the first place. because the older receivables get.. Getting paid by troubled companies generally takes an executive decision. it would rarely be wise to come right out and say that. the trick is to get the debtor to prioritize our bill over those of other vendors. because under normal conditions the credit department takes care of that. that pitch generally has to be made to the president. not "you" made the decision. and the salesperson has much better access to that office than the bill collector. The idea is to gently remind the president of how the situation came about without accusing anyone of fault. In collecting from cash poor companies. This has created a delinquency situation that we have to work together to resolve. we should probably get ready for some loss whatever we do. People in the customer's payables department don't have the authority or motivation to do that. (Notice the wording of the first four paragraphs. Can you argue that finance is completely without fault in this matter? ANSWER: Receivables are ordinarily considered the responsibility of the finance department. Without that we're unlikely to collect much. It's therefore imperative that the collections department get some help from sales to work the overdue receivables. The sales rep is in the best position to present the customer with the reality that unless the old bill is paid. The problem is the fault of the president and the VP of marketing. In small cash poor companies. In the situation at Wachusett Window outlined in the last question. Salespeople don't generally worry too much about credit worthiness. In this case. we made the decision to extend credit despite concern about several customers' ability to pay. In the normal course of events receivables come from credit sales proposed by the sales/marketing department and approved by the credit and collections department. and its better not to surprise the president with that later.. and routinely lay the blame for mistakes elsewhere. It signifies a judgment by specialists that the debt is likely to be collectible. the credit department starts calling and writing the customer.

000 + $655. An estimate can then be made of the financial consequences of each stockout. of course. but those effects are buried in the financial results and aren't explicitly identified as being the result of inventory problems.000 655. Compiling a list of all stockouts every month for management review will go a long way to motivate some attention to watching inventory levels more closely. They frequently aren't identified until times get tough and people start to look for ways to increase sales and lower cost. the company is profitable.The Management of Working Capital 132 ANSWER: No. Wildebrant Inc runs out of inventory all the time both in the factory and at the point of sale. The fact that sales is unwilling to help in the collection effort is probably rubbing salt in the wound. such inefficiencies tend to be overlooked. ANSWER: It probably isn't too good.200 Working Capital = Gross Working Capital – A/P – Accruals . An additional discount would probably hurt because it would be taken by customers who are already paying on time. Scherbert Industries has the following balance sheet accounts as of 12/31/x3 (not a complete balance sheet): Accounts Payable Accounts Receivable Accruals Cash Common Stock Fixed Assets (net) Inventory Long Term Debt $650. and no one worries about it much. Shortages result in lower sales when they prevent filling orders and higher costs when they disrupt production.250.000 845. Speculate on the nature of the relationship between the credit and collections department and the sales department at Wachusett Window in the last two questions.000 3. Is this ok? What's probably going on that management doesn't see? Why don't they see it? What would you suggest to fix the problem? How would it work? ANSWER: The problem is that the cost of running out of inventory isn't identified on financial statements.000 = $1. PROBLEMS Definitions: (pages 665 – 667) 1.000 257.637.500 137. When a company is profitable. This.200 1. SOLUTION: Gross Working Capital = Cash + A/R + Inventory = $137. 7. The problem can be addressed by a tracking system that creates a report whenever a stockout occurs. because the firm could be doing even better in good times if it controlled inventory more effectively.200 + $845. Credit and collections is likely to be resentful of the override of their rejections and to be really upset that the accounts are now proving to be problems. The problem customers aren't likely to have the cash to pay their bills promptly regardless of the incentive offered. is a mistake.000 8.200.500.000 Calculate gross and net working capital. 6. However.

400.$650.000. b.500 = $729.5%. c.667 $1.000.000 b.000 +$10M  .000 .667 The decision is subjective depending on the firm's profitability and the likely prospects for future increases in short term rates. has an inventory turnover of 10X.637.12 (4/12) = 400.000 $2. It requires a permanent base of net working capital of $10 million all year long.133 Chapter 16 = $1. Finance all net working capital needs with short-term debt at 12. Langley has three financing options for net working capital. a.$257.600. Which would you choose? Why? SOLUTION: Net W/C levels: $10M for 8 months $20M for 4 months a. an ACP of 45 days.125(4/12) = 416.700 Cash Conversion Cycle: Figure 16-2 (page 669) 2.000 $3.200 . but that requirement temporarily increases to $20 million during a four-month period each year. $10M  .000 $10M  .) SOLUTION: Inventory Conversion Period Operating Cycle = 360/10 = 36 days = Inventory Conversion Period + ACP = 36 + 45 = 81 days Cash conversion Cycle = Operating Cycle  Payables Deferral Period = 81  30 = 51 days Working Capital Financing Policies: Example 16-1 (page 673) 3.000 +$10M  . net 30 . Southport Inc.000 c. Finance permanent net working capital with equity and temporary net working capital with a short-term loan at 12%. Prompt Payment Discount (page 675) 4. using a 365-day year. and turns over its payables once a month. Calculate the cost of each option.06 (8/12) = 400. Finance the peak level year-round with equity which costs 20%.20 = $2.125 = $1. Calculate the effective interest rate implied by the following terms of sale.20 = $4. The Langley Corporation is in a seasonal business. and invest temporarily unused funds in marketable securities which earn 6%. How long are Southport's operating and cash conversion cycles? (Use a 360-day year. 2/10. $10M  . $20M  .250.666.

SOLUTION: The interest rate on borrowing is 6% + 2% = 8% Monthly rate is 8%/12 = . I.01 = 14. Revolving Credit Agreements: Example 16-2 (page 678) 6. pay on the net date.9% b. however. which discounts should it take and which should it forego if it pays 18% for working capital financing? Why? SOLUTION: a. net 25 1/5. Rocky should forego the discounts. A B C D (365 / 20) x . vary considerably as follows: A 2/10. net 20 SOLUTION: (365/20)  2 = 36. can buy its inventory from any of four suppliers all of which offer essentially the same pricing and quality.25%/12 = .6667% (multiply by . it should avoid borrowing from suppliers A and B. On the other hand.0002083) First half of month: $5M  .5/10. net 90 a. net 30 B 3/5.125% (365/15)  2. net 30 2. Calculate the implied interest rate associated with each policy.006667) Interest charges: First half of the month: $ 5M  . net 15 .0002083  ½ = $ 520.667. Rocky Inc. Their credit terms. Last month Thompson had borrowings of $5M for the first half of the month and $10M for the second half.6% (365 / 85) x .02083% (multiply by .5% (365/10)  1 = 36. has a $10M revolving credit agreement with its bank.02 = 36.833% (365 /15)  1 = 24. b.0% (365 / 25) x . net 45 D 3/5. Hence Rocky should pay promptly and take the discounts from suppliers A and B. The bank’s prime rate is 6%.333% 5.5 = 60.00 The monthly commitment fee rate on unused funds is .The Management of Working Capital 134 1/5.e.5% (365 / 15) x .50 . It pays interest on borrowing at 2% over prime and a ¼% commitment fee on available but unused funds.. Rocky is effectively borrowing at the rates calculated in part a if does not take the discounts offered. because those rates are much higher than the 18% it pays for working capital financing. net 20 C 1/20. and effectively borrow from suppliers C and D. Thompson Inc.03 = 12.006667  ½ = $16.5/10.335.5% (365/20)  1/2 = 9. because those rates are lower than the 18% it pays for working capital financing.03 = 73. If Rocky buys some material from each vendor.006667  ½ = $33. Calculate its interest charges for the month.50 Second half of the month: $10M  .

000 + $417 + $278 = $35.135 Chapter 16 Second half of month: none $ 0.0002083  20/30 = $277  $278 Total financing charges are the sum of these $30.8M = $7.75% (multiply by . it had taken down $15 million that was outstanding for the entire month.000  .000 $6.695 8.0075  (20/30) = $30.000 for the last 20 days $2. SOLUTION: Interest monthly rate: 9%/12 = . If the current accounts stay relatively constant throughout the year. The bank is willing to lend the company enough to finance its working capital needs under a $10 million revolving credit arrangement at a base rate of 12% with a 3/8% commitment fee on the unused balance.8M Interest = $7. On April 10.500. The firm had borrowed $2 million going into April and borrowed an additional $4 million on April 11.900.8M  . The Grass Ridge Company has the following current asset accounts Cash Accounts Receivable Inventory $1. Prime is 8.000 = 10. Calculate Canejo’s interest charges for April.000.25%/12=.2M  . and the . Bridgeport Inc has a $30 million revolving credit agreement with its bank at prime plus 3.000 Commitment fee monthly rate: .5:1. Prior to the month of April.2% based on a calendar year.000.0075) $2. The Conejo Corp.2M = $2.000 was outstanding for the last twenty days of the month $6M  .25 7.0075  (10/30) = $5.000.000 + $5.500 9.000 was outstanding for the first ten days of the month $2M  .00 $50.8M Net W/C = $12M  $4.2%.600.000.000 $4.02083% (multiply by . it took down another $5M.000 $5.000 Its current ratio is 2. No further borrowing or repayment was made during the month.000.500 $874.000  . It pays a base rate of 9% on its outstanding loan plus a ¼% commitment fee on the unused balance.523.0002083  10/30 = $417 The unused balance was $2.000.000 for the first 10 days $6. borrows from its bank under an $8 million revolving credit arrangement.5 = $4. what will Grass Ridge pay the bank for working capital financing? SOLUTION: C/L = $12M/$2.0002083) The unused balance was $6.2M = Average amount borrowed Unused commitment = $10M  $7.00375 Total W/C financing charges = $864.12 Commitment fee = $2.

353% 14/.333% 10.0208% monthly Outstanding in April: $15M for the whole month $ 5M for 2/3 month Unused balance: $30M  $15M $30M  $15M  $5M = $15M for 1/3 month = $10M for 2/3 month Interest: [$15M + (2/3)$5M](.4% => . 8.5% 20% b.427 $176.8 = 8.594 Compensating Balances: Example 16-3 (page 679) 10.5/.000 loan at 8% for 120 days if a 20% minimum compensating balance is required? SOLUTION: 8%/(1  . A finance company.9 = 13. .200.95% monthly commitment fee = . 6.167 Commitment fee: [(1/3)$15M + (2/3)$10M](. Climax Inc.0% 25% e.20) = 10% 11. Because the business is small and relatively new.7 = 12. 10.667% 8. b.75 = 18.5/. Climax will lend 70% of the average receivables balance for 14% plus an administrative fee of $1. Calculate the charges associated with Bridgeport's revolving credit agreement for the month of April.85 = 12.143% Pledging Accounts Receivable: Example 16-4 (page 681) 12.2% = 11. The bank has offered such a loan at 25%.5% 15% d. SOLUTION: k = 8.125% 12.25% annually.000 and $60. 6. 12.25% => .0% 10% c. unsecured loans are very hard to get and are expensive when they are available. d.0/.5/. 14. e.The Management of Working Capital 136 bank's commitment fee is . Calculate the effective interest rate on loans with the following minimum compensating balance requirements: Loan Rate Compensating Balance a. What is the effective interest rate on a $750.000 for approximately sixty (60) days.2% + 3.5% 30% SOLUTION: a. Jenkins Appliances has cash flow problems and needs to borrow between $50. has offered an alternative loan if receivables are pledged as collateral. c..0095) = $174.000208) = 2.

000 x . The bank generally accepts 60% of the accounts offered and advances cash equal to 85% of those.050 .600 Average loan balance = $55. SOLUTION: Amount advanced per year = $250M  .506.125 $ 3.137 Chapter 16 Jenkins’ average receivables balance is $80. It offers all of its receivables to its bank as collateral for short-term borrowing (pledging).8 = $200M Average amount outstanding @ 10% = $200M  .14 = $2.8M Administrative fee = $250M  .5%:  .000 Administrative charge rate:  . so receivables “turn over” ten times a year. so 10% of the annual amount advanced is generally outstanding at any time.000 x 70% = $56.5% + 3% = 12.60  .8M = $6.8 / $20M = 34% 14.000 Cost of 25% loan for 60 days: $56. which turns over once every 30 days. Interest is 3% over prime and the bank charges a 1% administrative fee on the gross value of all accounts offered.333.050 Interest rate = 9. pledges receivables of $250M per year to the Sharkskin Finance Company which advances cash equal to 80% of the face value of the accounts pledged. SOLUTION: Assume that the loan will be $80.01 Administrative fee $ 6.200 = $2. Assume the bank is willing to lend the same amount as Climax. What is DeSquam’s cost of receivables financing? State the result in dollar terms and as a rate. (36 days is one tenth of a year.106 Effective interest: Total Financing Charges $10. DeSquam’s receivables are usually collected in about 36 days.000 x .000  .0M + $2.33 Cost of pledging: $56.14 x 60/360 + $1. DeSquam Inc.) Sharkskin charges 14% interest plus an administrative fee of 1. The York Company has an average receivables balance of $55. The prime rate is currently 9.000.506 Total financing charges $10.6% of the amount pledged.000.10 = $20M Interest on loan = $20M  .25 x 60/360 = $2. What effective rate is York paying for its receivables financing? SOLUTION: Gross amount offered = $55.8M Charges as a % of avg loan balance = $6.0% Average Loan Balance $28.016 = $4M Total financing charges = $4.5%.106   36. Which alternative should Jenkins choose? Calculate using a 360-day year. 13.000  12 = $660.85 = $28.67 Hence the bank loan is cheaper.

000 plus 2% of the value of all the inventory it handles.The Management of Working Capital 138 Factoring Receivables: Example 16-5 (page 683) 15.5M Total charges = $16. a. Should the firm do it if bad debt losses are expected to average 3% of gross sales and running a collections department will cost about $1. What is the implied interest rate in the factoring arrangement if the costs in part c are taken into account? SOLUTION: a.000 + ($15. Because the factor doesn't collect from customers until they pay.000 Interest on average loan balance = $1.9M Southern is better off to do the job itself.67% Inventory Financing: Example 16-6 (page 684) 16. What will the cost of financing be under this proposal? State the result in both dollar and percentage (of amount borrowed) terms.5/365) = $15M Implied interest = Total financial charges/loan balance = $16.5M  $5. b.9M)/$15M = 70.000 / 5 = $3.5M $5.000.5M = $1.02) . Southern Fabrics Inc factors all of its receivables. The factor operates without recourse and pays immediately upon taking over the accounts. Suppose Southern is considering giving up the factoring arrangement and handling its own collections. since the cost is considerably less than the $16.000  .000. The bank also insists that Williams employ a warehousing company to monitor and control the inventoried material. Williams moves inventory valued at about $15M through its plant each year at a turnover rate of 5 times. It discounts by 10% the gross amount factored and pays Southern immediately.000. What interest rate is implied by the arrangement? c. Factor's Discount = $150M  .800.9M = $1. The firm does $150 million in business each year. The firm's gross margin is 35%. d.000  . 60% of the value of its inventory at 12% if Williams will pledge the inventory as collateral for the loan. Central City Bank will lend Williams Inc.5 / 365)  .65 Collection department expense Interest on A/R balance @ 10% = $2.000 Handling fee = $150. ($16. Ordinary A/R balance = $150M  (36.5M/$15M = 110% c.12 = $216.000  .5 million per year? Assume the interest cost of carrying the receivable balance is also 10%. SOLUTION: Average inventory balance = $15.000. it charges interest at 10% in the interim.5M the firm is paying to the factor. Blyth Warehousing will do the job for an annual fee of $150.5M b. The cost of doing the collections job includes the cost of product lost on the bad debts (not the entire amount of the lost revenue since the gross margin on those sales isn't an actual loss) and the cost of running a collections department. and would have an ACP of 36. d.800.6 = $1.10  $150M = 1%  $150M = $1.000 Average loan @ 60% of inventory = $3. Bad debt losses = $150M  3%  .10 = $15M Interest = (36.5 days if it collected its own receivables. Calculate the gross cost of factoring to Southern Fabrics if all receivables are collectible.

A warehousing company will install and operate the system for $800. The Bridgewater Bank is willing to advance financing of 75% of the value of Shamrock's inventory at an interest rate of 12%.000 = $666.200 = 10.333 Float reduction $ 33.20  10.000 + $450.000 Total charges = interest + handling = $216.005 = $200M  .0M Base charge: .75 = $15M Warehousing as a percent of loan = $1.000 Cost of lock box system Number of checks per year $12M / $1.000 = $2.800. SOLUTION: Interest savings on the available funds are: Current amount in float $12M  (8/360) = $266.500 Hence the cost exceeds the savings by $1.005 = $1.667 Proposed amount in float $12  (7/360) = $233.50 per check.20 per check.200. Tambourines Inc.500 Total cost $4. which is completely replaced approximately 10 times a year.000 = $450. collects $12M per year from customers in a remote location.500. Should Tambourines install the system? Use a 360-day year.500 per year so the system should not be installed.8M/$15M Plus traditional interest Total effective financing charges = 12% = 12% = 24% Evaluating Lock Box Systems – Example 16-7 (page 692) 18. The checks take an average of nine days to clear into Hadley's Florida bank. it requires a warehousing system to secure its interests.334 Interest saved on float reduction at 9% $ 3.000 Annual base fee: = $2.000 + $300. A lock box system would shorten the overall float on these receipts from 8 days to 7 days.000 Financing cost as a % of average loan = $666. Sales to those customers are $30 million a year paid in checks that average about $1. a. The average remittance check is $1.5% of the value of materials entering the system.000 / $1.500 per year plus $. The system can be expected to reduce the clearing time to six days. 19.8M Average loan amount advanced: $20M  . However. The Hadley Motor Company is located in Florida but has a number of customers in the Pacific Northwest.000 a year plus .000 a year plus $. What is the effective cost of this financing to Shamrock? SOLUTION: Entering inventory charge: $20M  10  . A bank in Oregon will operate a lock box system for Hadley for $8. Is the lock box system worthwhile if Hadley borrows at 13. The relevant interest rate is 9%.000 Per check charges: $. but would cost $2.5%? .8M Total warehousing charges $1.139 Chapter 16 = $150.000 = 37% 17. The Shamrock Company has a raw materials inventory of $20M.

000C .50 = $10.000 Fixed cost = 8.$10.288 Costs: # of checks = $30M/$1. The cost of the system is $0.62 days 20.000 Colburn funds its accounts receivable with short-term debt at 8%. Colburn Inc.000 If C = per check charge Colburn would be indifferent if the cost of the system was equal to the interest saved or $160.000 Variable cost = 20.$99.135 = $33.000 = 18.$180 million Average check .000/$11.0005 + $. b.05% of the gross revenues processed.000 The lock box is a good idea since the interest savings exceeds the cost. What is the minimum number of days of float time the system has to save (to the nearest tenth of a day) to make it worthwhile? SOLUTION: a.000 = $61.000 Implementing would save $160.000  $.000 = 18.000 = $99.000 $18. at what per check charge would Colburn be indifferent to lock box arrangement? SOLUTION: Number of checks: $180 million/$10.000C $70. is considering a lock box system. Interest saving per day of float saved: ($30M/365)  . Should Colburn implement the lock box system? If the charge based on gross revenue remains constant. First Bank has indicated their lock box system will reduce mail float by an average of one day and eliminate internal processing time. plus 0.500 = 20.000 = $90.096 Minimum # of days to make system pay: $18.50 x 18.The Management of Working Capital 140 b. Float reduction: $30 M  9  6 days  $246.096 = 1.135 = $11.000 checks Reduction in A/R: $180 million x 4/360 = $2 million Savings in interest expense: $2 million x .575 365 days Interest savings = $246.08 = $160.000 .575  .50 for each check processed. The firm has analyzed its credit receipts and determined the following: Average time checks are in mail – 3 days Average internal check processing time – 3 days Average to clear the banking system – 2 days Total credit sales .000 Cost of new system: $180 million x .000 + 18.

6% of revenue.141 Chapter 16 C = $3.000 = (Days/360) x $630 million x .0006 + (.000. Finance has suggested that credit policy be tightened to reduce bad debt losses.000  .800 + $200. The Bailey Machine Tool Company thinks it can increase sales by $10M by loosening its credit standards somewhat.06% of total receipts. The firm normally experiences bad debts of about 2% of sales. a. SOLUTION: a.12 $378. The contribution to profit from new customers that pay is $10. but bad debts are now at 6% of sales.500.394.24 x 420. b. c. Should Bailey lower its credit standards to get the new business? b. Under the current policy Golston’s revenue forecast is $400 million with a contribution margin of 38%.000  . Should the new policy be implemented if bad debts only are only expected to drop to 4% of revenues? . Bozarth Business Machines (BBM) has analyzed the value of implementing a lock box system.89 21.000 invoices cost of the system + net annual benefit = interest savings $630 million x . What non-financial considerations should be evaluated.000 = 3.82 = $1.24 per check and .000 per year. How many days does BBM expect the system save in the collection process? SOLUTION: Number of invoices: $630 million/$1. but marketing estimates that the incremental business would be from financially weaker customers who would not pay about 17% of the time. Implementing the new credit policy wouldn’t have an effect on contribution margin but would require an additional $500. BBM has estimated that the lock box will save $200. Another $150. Would your answer change if taking on the new business also involved incremental collection expenses of $150.000 = $210.83  .000 annually.000 in cost makes the project marginally unacceptable (by $50.000.23 Days Credit and Collections Policy: Example 16-8 (page 696) 22. That’s probably not enough to make implementing the plan advisable because of the inaccuracies inherent in making estimates like these.000 (Note that the loss on an uncollected debt is just the cost of the product sold.000 + $100. 494. Their proposal calls for a more restrictive policy under which sales would fall by 8% but bad debt losses would drop to 2. Should Goldston implement finance’s new credit policy? b.000 (Days) Days = $678.17  . The firm’s gross margin is 18% (production related costs are 82% of revenue).500 = 420. 23.000 The loss on bad debts associated with new customers that don’t pay is $10. not the entire revenue amount that includes the profit that would have been made on the sale. Over the past few years. The firm anticipates revenues of $630 million with an average invoice of $1.000).) Hence the loosening of credit standards looks marginally profitable by $100.800/$210.000 in annual fixed costs. Revenue has risen as a result.18 = $1. a. which would make the argument against doing it even stronger. the marketing department at Goldston & Co has convinced the finance department to permit credit sales to increasingly marginal customers.000) + $200. BBM borrows at 12% and has made an arrangement with Old Second Bank to manage a lock box for $.000 per year.

772.620 Operating income is $3. since the added margin on new sales exceeds the expected losses and costs. Will the tighter policy offend existing customers who may pay slowly but who Golston nevertheless wants to keep? With New Plan Cash from sales 400.7 = $1. Kranberry is contemplating an easing of its credit policy in an attempt to increase sales.62 = 228. No. Economic Order Quantity Model (EOQ): Example 16-9 (page 704) . Original With New Plan Cash from sales 400.92 x . but not by those who create collection problems.772 Operating income is $1.000 x . The Kranberry Kids Klothing Kompany is in the volatile garment business.96 = 353.160 Contribution margin 125.4M Cost of bad debt losses = $2. and that internal collection efforts would cost an additional $1 million a year.3M Bad debt losses on new business = $20M  .000 lower with the new plan so it shouldn’t be implemented. The loosening would involve accepting a lower quality customer for credit sales.974 = 358.12 = $2.0M Total loss/cost = $2.4M  .000 x . Is it likely that coupling an increased prompt payment discount with the looser guidelines would reduce the bad debt losses? c.380. Is the policy change a good idea? b.280 Variable Costs 400.92 x .000 130. Bad debt loss rate = 3%  4 = 12% Margin on added revenue actually collected = $20M  . It is estimated that sales could be increased by $20 million a year in this manner.62 = 228. the collections department estimates that bad debt losses on the new business would run four times the normal level.30 = $5. a.000 x .62 = 248. However.7M Collection effort = $1. b.000 400.272 Relevant Fixed Costs 0 500 Operating Income 128.The Management of Working Capital 142 SOLUTION: ($000) a.000 x .000 x . The firm has annual revenues of $250 million and operates with a 30% gross margin on sales.88  .160 Contribution Margin 128. c. An increased discount might hurt because it would be taken by customers who are already paying on time.000 400. Is it possible that the idea in part b could have a net negative impact? How? SOLUTION: a.7M The policy change looks like a good idea.432 Variable Costs 400.94 = 376. b. Bad debt losses average 3% of revenues.000 higher with the new plan so it should be implemented. because the new customers are likely to be so cash poor that they won't take the discount.000 129.92 x . 24.92 x . c.000 x .120 Relevant fixed costs 500 Operating Income 124.

What ordering quantity minimizes the inventory costs associated with the valves? (Round to the nearest unit.22 = $14. What are the valves' carrying and ordering costs if the EOQ is used? SOLUTION: a. Management has determined that the EOQ is 1.18  $25 = $4. carries an inventory of valves that cost $25 each. process.4  $38 = $1.000)/$4. How many orders will be placed each year if the EOQ is used? c. The firm projects product demand next year of 25. The firm's inventory carrying cost is approximately 18% of the value of the inventory. Smithson Hydraulics Inc. Sharon’s Sweater Shop orders 5.000 Hence EOQ = [2($38)(20. F = $52 and the product’s annual demand is D = 5.000 sweaters per year from a supplier at a wholesale cost of $65 each.000 Substituting we have EOQ = [2FD/C]1/2 EOQ = [2($52)(5. It costs $320 to place an order with suppliers. SOLUTION: The Economic Order Quantity is EOQ = [2FD/C]1/2 Where: The carrying cost per unit is C = $65 x . How much per year does it cost Emmons to carry a unit of inventory? .143 Chapter 16 25. F = $38. a.69 Hence Sharon should order approximately 191 sweaters at a time.000 units. Emmons Motors is a distributor of electric motors.000 / 191 = 26. 20.30 The fixed cost per order is. Ordering cost = 34.18 = $1. How many orders should Sharon place with the supplier each year and how large should each be.000)/$14. EOQ = [2FD/C]1/2 where: C = . It costs $38 to place. 26.307 27.50]1/2 = 581 b. and D = 20.) b. and it costs $52 to place and receive an order. and receive an order.30]1/2 = [36. At that quantity she’ll order approximately (5. Carrying costs are 22% of cost.000 valves a year.307 Carrying cost = (581/2)  $25  .64]1/2 = 190.18) 26 times a year.000 units.000/581 = 34.50. The firm uses 20.363.4 c.

000)1/2]/1000 = 4 C = $16 Just In Time (JIT) Inventory Systems: Example 16-10 (page 707) 28. d.000 Break even number of failures = $27. presumably unsophisticated suppliers located as far as 50 miles away will be able to make JIT deliveries missing only three times each year. However.500 / $9. Comment on the advisability of the JIT idea based on your answer to part a. During that time the assembly staff of 25 people will be idle.1 b. it will generally be a day and a half before it is finally received.000 parts inventory is financed with short-term debt at 6% interest.000 x . scrap the system.500 10. how many JIT failures can the system tolerate and still break even? b. Operating perfectly annual JIT savings will be Interest Shrink and Obsolescence .5 days = $9. a. Shrinkage and obsolescence cost about 1%.000 $27. c. slowly work down the existing inventory.06 = $15. It could also have negative consequences on EverFit’s relations with its own customers who may be anxious to receive product on time. Suggest a way to test the system before making a final decision. An extended delivery failure lasting several days or weeks could be a financial disaster.000 = [(2 x 320 x 25.500 The cost of a delivery failure is: 25 people x $30 per hour x 8 hrs per day x 1.01 = 2.000 $250. The parts are inventoried at EverFit’s factory and assembled for shipment to customers. If not.000. If the measure of the system is saving money.000)/C]1/2 C1/2 = [(16. while taxes and insurance run about $10. What qualitative factors might also be concerns? d. EverFit’s engineering department designs the equipment and then contracts with metal working shops to produce parts to their specifications. SOLUTION: a. the suppliers won’t be able to manage their operations precisely enough to consistently meet customer JIT requirements. c. manufactures commercial grade fitness equipment used in spas and health clubs. The firm produces complex resistance exercise machines designed to strengthen specific muscles. EverFit’s CFO is concerned that although their intentions are good. Further.000 = 3. Run the JIT system for a few months without getting rid of the existing inventory. EverFit has discussed a just in time (JIT) system with its suppliers all of which are located within fifty miles. and are willing to try to deliver parts in accordance with its production schedule. . use parts out of inventory If there are a lot of missed deliveries.000 x . The $250. It seems unlikely that small. The suppliers are small firms that depend on EverFit’s business. Each assembly worker earns about $30 per hour and must be paid for eight hours a day whether working or not. Hence the idea seems unlikely to be cost effective. When a delivery is missed.The Management of Working Capital 144 SOLUTION: EOQ = [2FD/C]1/2 1.000 per year. he thinks that when a JIT delivery is missed. EverFit Inc. Taxes and Insurance Total $250.

145 Chapter 16 .